martes, 23 de mayo de 2017

Desde IFRS Box

How to Make Consolidated Statement of Cash Flows with Foreign Currencies

Did you know that many groups prepare their consolidated cash flow statement completely incorrectly?
And, if you are well-experienced accountant, you can actually spot
the faulty numbers instantly when you look to the statement of cash
flows.
Sadly, this wrong method is often taught in many accounting courses.
What method is it?
Similarly as with the individual statement of cash flows, you take
the consolidated statements of financial position, consolidated
statement of total comprehensive income, then you calculate “deltas” or
the differences between the closing and opening balances of your assets,
liabilities and equity items…
… there you go, I described this method here with details in the video.
It’s very simple method and you’ll get nice consolidated statement of cash flows.But it’s incorrect.
Don’t get me wrong now – this method is perfectly OK for consolidated cash flows when the parent and the subsidiary use the same functional currency.
Therefore, if you both use EUR (or any other currency) – use it.
Or, if you attend an exam and the question gives you two sets of
financial statements, both in the same currency – use it. You’ll be
fine.
However, as soon as foreign currencies are involved, then I do NOT recommend using this method.
Why?
Because, it does not comply with IAS 7 Statement of Cash Flows.
The reason is that under IAS 7, you should apply the rates applicable at the dates of transaction, or at least the average rates prevalent during the reporting period.
You need to realize that the consolidated balance sheet was prepared
using the closing rates, because you had to translate all assets and
liabilities in different functional currency using closing rates.
Therefore, if you make consolidated statement of cash flows based on
the consolidated balance sheet, you are automatically using the wrong
translation foreign exchange rates.
As a result, the individual line items in your consolidated cash flow
statement would contain lots of effects of changes in foreign exchange
rates – and maybe you know that this effect should be reported
separately at the end.
How can you spot this wrong methodology in any financial statements?

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If you compare the effect of changes in foreign exchange rates in the
cash flow statement with currency translation difference in the balance
sheet, you’ll see it’s the same number.
It should NOT be!
So, what’s the right method?
Let’s explain in a few simple steps and illustrate on an example.

Example: Consolidated Statement of Cash Flows with Foreign Currencies

Hello, the UK company has owned 100% in GutenTag, a German subsidiary
since January 2015. The following transactions occurred in 2016:

On 31 October 2016, GutenTag paid dividend on EUR 1 000 to Hello.

On 30 November 2016, Hello purchased goods from GutenTag for EUR 5
000 (GutenTag’s cost: EUR 4 500). The goods remained unsold at the
year-end and the payable was unpaid.

The applicable exchange rates GBP/EUR:

31 December 2015: 0,7340

31 October 2016: 0,9005

30 November 2016: 0,8525

31 December 2016: 0,8562

Average in 2016: 0,8188

The financial statements of Hello and GutenTag as at 31 December 2016:

Prepare consolidated statement of cash flows for the year ended 31 December 2016.

In this step, you need to recalculate all the line items in subsidiary’s cash flows to show them in presentation currency.
What rates should you use?
Standard IAS 7 par. 26 and 27 clearly says that you should translate cash flows using the foreign exchange rate at the date of cash flow (transaction date) and you can use the average rate for the period for approximation.
Therefore, we can use the average rate in 2016 and for the specific
cash flow – dividends paid – we use the actual rate valid at the date of
cash flow.

Please note that we did not use any specific rate for translating the profit before tax. So where does the amount of GBP 14 907 come from?
This amount comes from the statement of profit or loss of GutenTag translated to presentation currency.
The reason why you should use it is that the individual items in
profit or loss can be translated using different rates (average vs.
transaction date) and the total profit figure is calculated.
I attached the excel file with all these calculations into the IFRS Kit, so if you are subscribed, you can check it there.
Also, please note that the opening balance of cash was translated
using closing rate in 2015, and the closing balance of cash was
translated using closing rate in 2016.
This is perfectly right, because these numbers must correspond with the consolidated balance sheet.
However, if you sum up all the movements, then the net decrease of cash plus opening cash balance in GBP do not give you the closing balance of cash in GBP.
Yes, because you applied different translation rates.
Therefore, you simply add the extra line – “effect of exchange rate changes on cash” and this would be your balancing figure.
Actually, it’s possible to verify this number by recalculations.

Step 3 – Aggregate parent’s cash flows and subsidiary’s cash flows

Simple as that.
Put both statement of cash flows in the same presentation currency next to each other and sum up. Done.

Step 4 – Eliminate intragroup transactions

This step requires some work to do and that’s probably the reason why
many groups try to avoid this method and prepare cash flow statements
from the consolidated balance sheets.
When you are eliminating, please be extremely careful about the exchange rates you use.

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In general, you should use the same exchange rates as were used at preparing the individual line items.
I’ll explain.
In our example, we need to eliminate 3 items:

Dividends paid by GutenTag and received by Hello
Sure, this is an intragroup transaction and if you report 2 companies as 1, nothing happened.
You should eliminate the dividends exactly from the affected captions:

Profit before tax: Parent’s profit was increased by the dividends, so we must bring it down (deduct dividend)

Adjustment for finance income and expenses net: The net expenses
were added, but they were lowered by the dividends paid, so we must
increase them again (add dividend)

Dividend received: No dividend was received by the group, so deduct.

Divided paid: No dividend was paid to the group, so add back.

The sum of these adjustments shall be zero. Look to the first adjustment in the picture below and see.
By the way, we used the same rate for all 4 entries, because we
assume that the parent recognized the dividend income using the
transaction date rate; and the dividend paid in subsidiary’s statement
of cash flows was recalculated using the same rate.

Intragroup receivable and payable of EUR 5 000
Similarly as with balance sheet, we do the same thing here.
We eliminate as follows:

Subsidiary GutenTag had receivable of EUR 5 000 to the parent. This
affected the increase in trade receivables’ line. Without this
intragroup receivable, the decrease would have been lower by 5 000 EUR,
so we add this amount back.

What rate?
Subsidiary’s cash flow statements were translated using average rate,
so we translate the elimination in the decrease with average rate, too.
As a result, you add GBP 4 094 back to the line “increase in trade receivables” (5 000*0,8188).

Parent Hello had an intragroup payable of EUR 5 000. This affected
the decrease in trade payables’ line. Without this intragroup payable,
the decrease would have been higher by 5 000 EUR, so we deduct this
amount.

What rate?
Parent’s cash flow statement was prepared from its balance sheet and
the intragroup payable was translated by the closing rate there.
As a result, you deduct GBP 4 281 from the line “decrease in trade payables” (5 000*0,8562).

The difference between GBP 4 094 and GBP 4 281 resulted from the
application of different exchange rates and therefore, you need to
report GBP 187 in the line “Effect of changes in foreign exchange”.

Unrealized profit on inventories
The parent bought inventories from the subsidiary and the subsidiary
made profit of EUR 500. The inventories remained unsold by the group at
the year-end, therefore in fact, no profit was realized from the group’s
view and we need to eliminate it in the statement of cash flows.
We eliminate as follows:

Subsidiary GutenTag made profit of EUR 500 and reported it in the
line “Profit before tax”. We need to deduct EUR 500 from that line.

What rate?
In subsidiary’s profit, intragroup sale was translated using the
actual transaction date rate, so use the same rate when eliminated
unrealized profit.
Therefore, we deduct GBP 426 (EUR 500*0,8525) from the line “Profit before taxation”.

Parent’s inventories are overstated by the unrealized profit of EUR
500 and it affected the line “increase in inventories”. Without this
profit, the increase would have been lower and therefore, we need to add
it back.

What rate?
UK parent recognized the inventories at the transaction date rate
(historical rate). The inventories are non-monetary item and therefore,
they remained the same, without recalculating by closing rate, at the
year-end.
Therefore, we add GBP 426 (EUR 500*0,8525) back to the line “Increase in inventories”.

That’s it.
The last step is to sum up aggregated numbers with all adjustments
and here you go, you get a nice consolidated statement of cash flows in
the last column.

Final word and a video

This was the illustration of the consolidated statement of cash flows using indirect method. If you use the direct method, the principles are basically the same.